Bidding Out the Profit

Scott Irwin's colleagues cringed when the University of Illinois ag economist stated, “The real winners with today's higher prices are landowners. If history is any guide, we will see every ounce of the operating margin bid into land and cash rents.” Or, said another way, there isn't a farm program or price level that farmers won't bid the profit out of.

It's not the sort of thing farmers like to hear. No matter how true it might be.

But while his colleagues cringed, Irwin stands by the statement. “Profits will ultimately dip back to historical levels of roughly $50-60/acre as land and production costs rise to keep pace with new-era prices,” he says. “Human psychology never changes.”

Easy money never lasts, according to Wells Fargo Ag Economist Michael Swanson. “But there's always money to be made,” he says. “Last year and 2008 were the years to make the easy profits. Next year and beyond represent a return to the commodity world's typical approach. You'll need to grind out a profit through superior management and discipline.”

Higher prices, in that case, are only a short-term fix for profitability. But the lag between new commodity price levels and the market adjusting to them is much shorter than it used to be, according to Irwin.

“Normally there's a lag of two to three years between price increases and increases in cash rents and land values. But throughout the recent price boom, from 2006 through 2008, I've been surprised how quickly and efficiently cash rents and land values have adjusted, or in some cases, over-adjusted,” he says. “You've got a much smaller number of highly competitive, well-leveraged operators who penciled it out quickly.”

SHRINKING MARGINS CAN'T all be blamed on farmers, points out Texas A&M Ag Economist Danny Klinefelter. “It's how free markets are supposed to work,” he says. “The function of a competitive market is to drive returns of the average producer to break even.

“Either production increase — which lowers prices — or input costs are bid up” he says. “That leaves them with a minimal return to owner equity, labor and management, and drives out economic profit. Profits beyond the market return to those resources in their next best alternative use.

“If there's a pool of money at the bottom, it ends up getting bid into land. Land is the ultimate residual claimant of higher prices,” Klinefelter says. “It wasn't that long ago that we had $2.50 corn and farmers said they would be profitable if only the price was $4. Now we're looking at an average corn price of around $4.60 and they're wondering if they can break even next year.”

If margins do return to $50, it won't bother Bloomington, IL, farmer Jason Lay. “It's just the nature of the beast,” he says. “Everyone is so competitive, and that's not just in agriculture.”

Is it bad?, Lay asks rhetorically. “It focuses everyone to be more diligent. You become leaner and meaner as a manager,” he says. “It fuels you to do more with less.”

Lay figures if the average margin is $50, he'll net significantly more than that. His goal is to maintain his operation in the top one-third of agriculture. “As long as I can maintain that position, I'll be viable. I don't think I'm in an industry that's going to lose two-thirds of its producers in the next five years,” he says.

“Setting that goal puts you in the right mindset. You're forced to know your cost per bushel and how you compare to the rest of the industry.”

And that's a mindset that's common among the nation's best farm managers, according to Klinefelter. “Those who are successful financially over the long term are exceptional in one of three main categories and above average in the other two. Those categories are marketing, production and being a low-cost producer,” he says. “Low-cost production is necessary, but not sufficient alone to maintain profitability over time.”

Even if average margins return to $50/acre, the top marketers will net much more, Klinefelter says. “When corn averaged $2.50, it traded in a range from $2 to $3. At a $4 average we're likely to see that range spread from $3 to $5,” he says. “If your average sales are just 10% above the average you've got an extra 40¢/bu. over the guy who just made average. On 200-bu. corn, that's an $80/acre advantage that you can compete with, that the average guy can't.”

Swanson warns farmers to not get blinded by the dollars it now takes to grow a crop. “Take a look at the input-output ratios and you'll see the market is simply tightening up to the standard ratios,” he says. “Over the last 14 years, cash rents have averaged a cost equivalent of 28% of the yield. If you double the output price, you should expect to double the cash rent price.”

Unfortunately, that logic tends to fall apart when farmers figure margins for labor and management. “If your margin was $50 when corn was $2.38, that's a 21-bu. return to labor and management. Now if corn averages $4.80, you should still expect the same ratio for return to labor and management, or $100/acre,” he says.

But, Swanson knows that's not likely to happen. “When it comes to returns to labor and management, farmers seem to think it lives in the same place as the tooth fairy,” he says. “They're not economists.”

Economically, however, growers shouldn't be happy with a $50 margin when their costs have doubled. “The financial risks are so much bigger; farmers need a bigger risk premium,” Irwin says.

Top operations each have different ways to beat the average. “On our farm, we take advantage of excellent grain drying and storage facilities and strip-till,” Lay says. “Other farmers have different skill sets that give them an advantage.”

In addition, successful people are more competitive by nature, according to Klinefelter. “They're driven to succeed. The concept of ‘enough is enough' isn't in their vocabulary,” he says. “They tend to acquire more technology sooner. The result is they have more time and more money to manage their operation.”

TO BEAT THE average, you also need to know what the limiting factors are for your operation and be able to compare your management style to other successful operators, according to Lay.

“For a 1,000-acre farmer, the limiting factor might be owning a full line of equipment without enough acres to support it. For larger operations it tends to be dealing with labor issues,” he says. “But whatever the limiting factors are on your operation, you need to identify them and fix them.”

Likewise, you need to be willing to adapt your management style to stay profitable, Lay points out. “Some guys want to rent or buy every acre they can; some take a wait-and-see attitude when the markets are volatile like they are now. Others claim the sky is falling,” he says.

“But one management style won't always be successful. You can't be caught up in doing things just one way, because that's the way you've always done it. Successful operators take the time to look at other ways of thinking about managing a farm,” says Lay.

Wells Fargo's Swanson adds, “You need to get out of your comfort zone. If you're operating your farm the same way you did five years ago, you're falling behind your competitors. New technology has increased efficiency dramatically.

It takes discipline, Swanson adds. “Sometimes you need to override your ego. Only about 60% of the acres farmed are moneymakers. Twenty percent of the acres break even and 20% lose money,” he says. “You need to resize yourself when needed and get off the poor land, even if your ego is telling you to farm as much as you can.”

If you do decide to battle cash rents beyond a reasonable level of return, be ready to do it on all your acres and be ready to suffer the consequences if the market moves against you, warns Lay.

“Don't think you can bid up one farm and keep your other landlords happy with a lower bid,” he says. “It doesn't hurt to let a piece of ground go if somebody starts a bidding war. You're better off working with your remaining landlords.”